Investors Provide Millions to Risky Start-Ups

Bill Nguyen, the founder of Color, a company whose highly anticipated app landed with a thud.Credit
Jim Wilson/The New York Times

PALO ALTO, Calif. — What if you threw a $41 million party and nobody came? A start-up company called Color knows how that feels.

In March, Color unveiled its photo-sharing cellphone application — and revealed that it had raised $41 million from investors before the app had a single user. Despite the company’s riches, the app landed with a thud, attracting few users and many complaints from those who did try it.

“It would be pointless even if I managed to understand how it works,” one reviewer wrote in the Apple App Store.

Since then, Color has become a warning sign for investors, entrepreneurs and analysts who fear there is a bubble in start-up investing. They say it shows that venture capitalists, desperate to invest in the next Facebook or LinkedIn, are blindly throwing money at start-ups that have not shown they can build something useful, much less a business that can provide decent returns on investment.

Color, which says it is overhauling its app, is just one of the start-ups that have set tongues wagging about bubbly excess in Silicon Valley. The Melt plans to sell grilled-cheese sandwiches and soup that people can order from their mobile phones. It raised about $15 million from Sequoia Capital, which also invested in Color.

Airbnb, which helps people rent rooms in their homes, is raising venture capital that would value it at a billion dollars. Scoopon, a kind of Groupon for Australians, raised $80 million; Juice in the City, a Groupon for mothers, raised $6 million; and Scvngr, which started a Groupon for gamers, raised $15 million. These could, of course, turn out to be successful businesses. The worry, investors say, is the prices.

They say they have paid two to three times more for their stakes in such start-ups over the past year. According to the National Venture Capital Association, venture capitalists invested $5.9 billion in the first three months of the year, up 14 percent from the period a year earlier, but they invested in 51 fewer companies, indicating they were funneling more money into fewer start-ups.

“The big success stories — Facebook, Zynga and Twitter — are leading to investing in ideas on a napkin, because no one wants to miss out on the next big thing,” said Eric Lefkofsky, a founder of Groupon who also runs Lightbank, a Chicago-based venture fund with a $100 million coffer.

A decade ago, in the first surge of Internet investing, it was not unusual for tech start-ups to raise tens of millions of dollars before they had revenue, a product or users. But venture capitalists became more cautious after the bubble burst and the 2008 recession paralyzed Silicon Valley.

Photo

Color’s app allowing people to share photos without logging-in, raised $41 million. Some analysts saw those figures as a warning sign.Credit
Jim Wilson/The New York Times

Meanwhile, it now costs less than ever to build a Web site or mobile app. So this time around the general philosophy has been to start small.

“By starting out lean, you have the chance to know if you’re on to something,” said Mark Suster, a managing director at GRP Partners. “If you start fat and the product concept doesn’t work, inherently the company will lose a lot of money.”

Two of Color’s photo-sharing competitors, Instagram and PicPlz, exemplify the lean start-up ethos. They started with $500,000 and $350,000, respectively, and teams of just a few people. As they have introduced successful products and attracted users, they have slowly raised more money and hired engineers.

Color, meanwhile, spent $350,000 to buy the Web address color.com, and an additional $75,000 to buy colour.com. It rents a cavernous office in downtown Palo Alto, where 38 employees work in a space with room for 160, amid beanbag chairs, tents for napping and a hand-built half-pipe skateboard ramp.

Bill Nguyen, Color’s always-smiling founder, has hired a team of expensive engineers, like D. J. Patil, a former chief scientist at LinkedIn.

“If I knew a better way of doing it, I would, but that’s what my cost structure is,” Mr. Nguyen said in an interview last week.

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Michael Krupka, a managing director at Bain Capital Ventures and one of Color’s investors, said Color needed to raise a lot of money because it planned to do much more than photo-sharing.

“When we get to the end product that we envision, people will realize how technically sophisticated it is, so we couldn’t do it with four people,” he said. “That’s expensive to do, so therefore I think the valuation’s a fair one.”

A serial entrepreneur, Mr. Nguyen, 40, said he had always raised more money than he needed so that if his products faltered, he had enough to keep going longer than his competitors. But it also means he has to sell the company to a bigger company or to shareholders for a lot more money than if he had raised less.

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Jonathan Kaplan, founder of The Melt, which planned to sell grilled-cheese sandwiches that could be ordered from mobile phones, raised $15 million.Credit
Noah Berger for The New York Times

He said the gamble was worth it, and it had paid off for him twice. He started a service for receiving faxes, e-mail and voicemail called Onebox.com, which Phone.com bought for $850 million, and Lala, a digital music service that Apple bought for $80 million last year. He also started a mobile messaging company called Seven, which has not yet sold.

Mr. Nguyen bounds around the Color office in bare feet and talks with implicit exclamation points at the end of each phrase, fueled by what he calls an addiction to Coke Zero. Despite his sprightliness, he says he has been chastened in the last three months.

“Your ego gets bruised a little bit,” he said. “There’s no doubt I wish we would have launched and millions of people would have used it, but that didn’t happen. The reality is we’re going to plug away at it and take a much more traditional route to go from A to B.”

“We live in a very favorable environment for start-ups right now, so if the number we raised was significantly larger than it would be at any other time, I’m not going to apologize for that,” he said.

At its start, Color said it would usher in a new era of location-based social networking, letting people share cellphone snapshots with other Color users nearby. But though it had some success at big events like music festivals, those who tried it elsewhere found that there was rarely anything to see.

Mr. Nguyen said the company had taken the criticism to heart and charted a new course. He fired Color’s president, Peter Pham, and its engineers are building a new version of the app to be released later this summer.

Mr. Nguyen outlined an ambitious plan to compete with Apple, Google and Facebook by tying together group messaging, recommendations and local search, all while making money through advertising. He plans to build applications that will use data from Facebook to create temporary social networks, say at a conference or sporting event, to help users meet people who grew up in the same town or like the same band.

Photos might not even be a part of Color in the future, he said, though an engineer hired away from the computer-in-a-pen company Livescribe is working on ways for people to doodle on photos. Analysts are curious about whether Color can pull off a do-over — and whether it and other high-priced start-ups can beat the long odds that all fledgling companies face.

“In every bust, there are ones that stand out and become Google, but that’s the exception rather than the rule,” Mr. Suster of GRP Partners said. “For every success there will be 250 really dumb valuations.”

Jenna Wortham contributed reporting.

A version of this article appears in print on June 20, 2011, on Page B1 of the New York edition with the headline: An Aura of Hope, a Touch of Dread: Investors Provide Millions To Risky Start-Ups. Order Reprints|Today's Paper|Subscribe